With sterling having fallen recently against the dollar, you’ll have noticed a tendency for the FTSE 100 to sometimes benefit from such weakness. In a sense, this represents a welcome return to normality.
My chart shows the point. Each point on the line shows the correlation between monthly changes in the $/£ rate and in the FTSE 100 over the previous five years. From the late 1980s to the late 2000s, this correlation was consistently negative. Falls in sterling, more often than not, were accompanied by good rises in the FTSE 100, and vice versa.
There was a simple reason for this, which we’ve seen recently. As sterling falls, the sterling value of foreign earnings rises. That’s good for FTSE 100 companies, most of whose earnings come from overseas.
You might think it odd that share prices that should embody the present value of future earnings are so sensitive to the current exchange rate. It’s not. The best (or least bad) predictor of the future exchange rate is the current one. A fall in sterling should therefore raise expectations of the sterling value of all future foreign currency earnings, which should be good for share prices.
Of course, this negative correlation has never been especially strong. But this is only to be expected because so many other things affect share prices. Most obviously, if global equities do well, the FTSE 100 will rise whatever sterling does.
It seems obvious, therefore, that there should be a moderate negative correlation between sterling and the FTSE 100, which makes it seem odd that for a long time this was not the case. During the 2008 financial crisis both the FTSE 100 and sterling fell together. And the two remained positively correlated until recently.
Again, though, there’s a simple reason for this. After 2008, markets became dominated by changes in global investors’ appetite for risk. When this fell – as it did in late 2008 – the FTSE 100 and sterling both slumped. And when it recovered, shares and sterling both rose; sterling is a riskier currency than many and so rises and falls with investors' appetite for risk, as do shares.
It’s for this reason that I say that the return to a negative correlation is a welcome return to normality. The fact that investors are focusing on changes in earnings expectations rather than upon swings in risk appetite is a sign of a return to the more stable environment we enjoyed before 2008.
Here, however, we have a problem. If a correlation can fall it can also rise. It’s perfectly possible that the positive correlation will re-emerge. One way in which this could happen would be if global investors lose their appetite for risk. Another possibility is that an adverse shock to the UK economy (such as a messy Brexit) might both hurt the pound and depress sentiment and earnings expectations of even FTSE 100 companies.
Such dangers obviously matter for overseas investors, especially if they are wondering whether to hedge their exposure to sterling. But it also matters for us UK investors. They are a reason why we might want to hold some foreign currency. If sterling and UK shares both fall, we’d lose on two fronts – not only would we suffer a loss of wealth but we’d also see a higher cost of living as import prices rise. Yes, this is only a risk. But the small chance of a nasty loss is something we should consider insuring against.
Beyond this, though, we should relax. Exchange rates are largely unpredictable and so we must not base our asset allocation decisions upon forecasts for them. Equally, we must not rely upon past correlations continuing. Instead, we should diversify and stop worrying and get on with our lives. But then, this is pretty much what we should do all the time.
